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04/12/2009

Reply to Comment on Housing--Posner

I reply to a comment on the following passage in my posting last week on housing: "The reallocation of income from consumption expenditures to very safe forms of savings reduces current consumption without increasing productive investment significantly, and so contributes to the depression." The commenter states: "surely much of the conservative savings are going into FDIC-backed bank accounts where each $100,000 backs over a million bucks of lending capability. So current consumption is reduced by one unit while lending in enhanced by 12 units?"
The error in the statement is the assumption that every dollar in an FDIC-insured bank account (or any other bank account, for that matter, according to the logic of the statement) is lent. Banks do not lend all their capital, especially in a depression. If a bank is undercapitalized, if it is worried that borrowers will default at an unpredictably higher rate (and that charging them a sky-high interest rate to compensate will increase the default rate), or if the demand for borrowing is down because many consumers and producers are overindebted and have to curtail their spending and avoid taking on more debt, then the bank will hoard most or even all of any cash it receives. Excess bank reserves, which are cash or equivalent (balances in the bank's account with a federal reserve bank), rose from $2 billion in August 2008 to $725 billion in March of this year. That is money the banks could lend (a bank is not permitted to lend its required reserves), but is not lending. This is rational hoarding, but it means that people who are depositing their money in bank accounts are not doing much if anything to increase lending and thereby stimulate economic activity.

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